What makes fiscal consolidations successful?

Athough I don’t detect that much interest in the expansionary fiscal contraction hypothesis, I think it is important we don’t try to reinvent the wheel. The determinants of successful fiscal consolidations was the subject of a large research effort in the 1990s. The following passages from a paper by Alesina, Perotti, and Tavares give a flavour of the findings:

“Empirical work on the effects and sustainability of fiscal adjustments has consistently reached two conclusions. First, long-lasting adjustments rely mostly (or exclusively) on spending cuts, in particular, in government wages and social security and welfare; by constrast, short-lived adjustments rely mostly on revenue increases. Second, fiscal adjustments are not always associated with reduced growth, or with a deterioration in the macroeconomic environment in general.” (p. 200)

“Fiscal adjustments that rely on cuts in government transfers and wages and are implemented in periods of fiscal stress are long lasting and not contractionary. On the demand side, the expansionary aspect of such fiscal adjustments works through an expectation effect, which is stronger the worse are initial fiscal conditions. On the supply side, the interaction of certain types of adjustment — those without tax increases but with cuts in government employment and wages — lead to wage moderation, reduced unit labor costs, and increases in profitability, business investment, and production.” (p. 214)

The Minister for Finance might be interested in this:

“Furthermore, governments do not seem to be systematically punished at the ballot box for engaging in fiscal adjustments, nor do they lose popularity, as measured by opinion polls. In principle, one can think of two explanations for this result. One is that voters do not like fiscal profligacy. The other is that governments are particularly skillful at choosing the appropriate moments to implement unpopular policies While it is difficult to decide definitively, we conclude in favor of the first interpretation.” (p. 241)

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13 replies on “What makes fiscal consolidations successful?”

You qoute “Furthermore, governments do not seem to be systematically punished at the ballot box for engaging in fiscal adjustments, nor do they loose popularity, as measured by opinion polls.”

Evening Herald 16 October 2008 “Blythe plummetted in popularity and lost his Dail seat and was blamed for helping to bring down the Government when he reduced the old-age pension from ten shillings to nine shillings a week in the 1920s.”

Particularly after the over 70s medical card situation recently one meddles with the seniors in our population with great care. The question is – Are the seniors the only section of the population who would exact retribution to such an extent?

What if any fiscal actions would bring the ABs back to government from Labour in the polls?

“A consolidation programme has to be designed as a comprehensive package. An ad hoc hodge-podge of measures will only have a limited chance of success. Presenting the consolidation measures in one package makes it clear to all interest groups that they are not the only ones being asked to make sacrifices.

“The idea is to signal that you are not partisan and that the budget deficit is a general problem that everyone should participate in solving. As a politician you can never explain why you need to cut pensions alone. But if, at the same time, you cut child benefit and unemployment insurance and raise income tax for the richest, you are on safe ground. The idea is to not single out the losers.”

Of course, it is easy for us economists to give such advice, especially in generalities.

Here are some more specific suggestions on the expenditure side, in part informed by the fiscal consolidation literature.

Social welfare: It is essential to protect people on low incomes. Having said that, it is a strange outcome to give unintendedly large increases in real payments in the midst of an economic crisis just because the inflation rate was overestimated. I would think this would be a relatively easy one for the government is properly handled. It could emphasise that it is absoltuely committed to the real increase announced in the budget, but that requires an adjustment is made based on the new outlook for inflation.

Defer capital investment: The seems an easy one politically, but I worry it is likely to be overdone from an economics perspective. (Patrick reminds us this course was taken back in the 80s.) The consoldiation literature tells us that what are perceived as permanent cuts in spending are both most sustainable and less likely to be contractionary. Temporary postponements of needed capital projects are less likely to be quite contractionary. Such investments also underpin productivity and competivemess going forward. In my view, now is the time to undertake them. Of course, projects that now look bad based on revised cost-benefit analysis should not be pursued.

Public sector wage bill: After the pension levy, I can see the government will be reluctant to re-visit this issue. Unfortunately, the thing that comes through loudest from the literature is the need to tackle both numbers and wages. I understand that the average reduction from the pension levy was 7.5 percent. Another 5 – 7.5 percent would be a defensible element of a comprehensive package.

John: Social Welfare. As unemployment rises and wages fall, the replacement ratio is rising. In the Republic the Jobseeker’s Allowance for qualified persons regardless of age ranges from a minimum of €91.80 to a maximum of €204. The UK (including Northern Ireland) Jobseeker’s allowance for those under 24 works is the equivalent of €54 a week. I wonder what it is in Latvia?

Brendan, you are braver than me. But I see your point. There is a danger of falling into a very bad equilibrium: high unemployment, a consequent high cost of unemployment benefits, high taxes and to pay for those benefits, all working to reinforce the high unemployment. A high unemployment situation will also make it harder to enforce a job test, compounding the high replacement rate problem.

The suggestion that Ireland experienced an expansionary fiscal contraction in the late 1980s was effectively debunked by John Bradley and Karl Whelan writing in Economic Modelling in 1997.
For the expansionary fiscal contraction to work the fiscal correction must so change expectations that consumers confidence is restored and they go out and spend and investors faith in the future is restored so they invest. Under current circumstances, without a turnaround in the world economy the governement could stand on its head and consumers and investors would still, rightly, remain pessimistic.
The arguments for further fiscal correction must stand on their own merit. The effect on growth of the necessary fiscal correction that is under way will undoubtedly be negative in the short term.

John, thanks for the pointer to the Bradley and Whelan article. The findings are largely consistent with my priors, especially the importance of the difference in the external environment during the 81-84 and the 87-89 adjustments.

Having said that, in reviewing the international literature the strength of the evidence for the EFC hypothesis has surprised me somewhat. (Of course, plausibly establishing causality with such data is always a difficult task.) In particular — and here I’m guessing you will disagree — I have been struck by the evidence for the superior performance of expenditure-based compared to tax-based adjustments. The government seems fixed on the wrong course.

From a strict macro perspecitve (admittedly only one of the relevant criteria) the evidence points to the surperiority of moderate expenditure-focused adjustment in April.

I say modest because, as you say, the most likely outcome of any fiscal adjustment is contraction. In responding to the lower than anticipated tax revenues, its seems sensible to respond partly by raising the deficit target, while putting in place a concrete medium-term deficit-reduction plan. Of course, the room for letting the deficit target increase limited, but a target of 10.5 percent of GDP seems like a sensible compromise given the risks on the other side of an even more serious collapse in domestic demand.